Eastern Europe

Ukraine Must Reform to Tap EU Energy Aid

With winter mere months away and cash-poor Kyiv struggling to pay its monthly gas bills to Moscow, many Europeans couldn't be blamed for worrying, "Will our heat be cut again this winter?"

The European Union, which receives most of its Russian natural gas imports via Ukrainian pipelines, is trying to prevent the next in what's becoming the annual Moscow/Kyiv gas standoff, one that last year left much of Europe with energy shortages in January. Backed by the EU, the European Bank for Reconstruction and Development (EBRD) and other international banks have laid out an approximately $1.7 billion aid package to help Ukraine pay for gas supplies during a recession that saw its GDP fall 18 percent last quarter year-on-year, and reform its domestic natural gas market to prevent future crises.

Despite media reports to the contrary, this is not a done deal. Kyiv must implement preliminary reforms before receiving any money. Because many of these will be politically unpopular and Ukraine will hold presidential elections in January, the lenders are reticent. But if the country's famously incompetent leadership can shape up long enough to start drawing the money, the package could prove a politically shrewd maneuver by Brussels.

"The EU is trying to seize on the silver lining in the clouds," said Tomas Valasek of the Center for European Reform. "It's an attempt to turn a crisis into an opportunity" to realize reforms by leveraging Ukraine's desperation during the global financial crisis.

The EBRD, World Bank, and European Investment Bank say the deal is in the early stages, and the figures are still preliminary. The EBRD is considering $300 million in gas payment support this year and a further $450 million next year; the EIB would offer $450 million to help modernize Ukraine's gas transit network; the World Bank's share would be $500 million in budgetary support, partially to help fund subsidies to offset the cost of reforms to consumers.

GAS PRICES MUST RISE

The banks say they won't offer a dollar until Kyiv starts meeting several conditions, evidently unique to each lender. Representatives of the EBRD and EIB wouldn't elaborate, but Andrew Wilson of the European Council on Foreign Relations said they, as proxies for Brussels, will be looking for a few key short- and long-term reforms to make Ukraine a more secure, transparent energy partner and corridor.

To start, a significant increase in domestic gas prices. Ukrainians buy gas at a fraction of the price national supplier Naftogaz pays Russia's Gazprom for the supplies. Reducing this subsidy would staunch the financial hemorrhage that is Naftogaz, replenishing state coffers and helping Kyiv meet its payments now and in the future. Last January Gazprom cut supplies partly due to mounting overdue bills, and Ukraine has had particular trouble keeping up this year because, given falling industrial output during the recession, Naftogaz agreed to buy too much gas at too high a price in its current contract.

Over the longer term, increasing transparency—Ukraine's gas market is widely perceived as corrupt—and efficiency are priorities. Ukraine's large but unreformed steel and fertilizer industries contribute to massive over-consumption, as does plain waste. Wilson, who lived in Ukraine in the 1990s, recalled how people would leave their stovetops burning around the clock during match shortages. Today the country is the seventh largest gas consumer in the world with only 46 million people.

The World Bank confirmed that gas price hikes are among its pre-conditions. It also wants Kyiv to guarantee aid for the poorest citizens as prices rise (the bank would fund this) and introduce more transparent public procurement laws.

NOW IT'S THE POLITICIANS' TURN

Prime Minister Yulia Tymoshenko has agreed to the lenders' reform demands in private negotiations, according to the European Commission, and has already moved on the gas prices. She has committed to a 20 percent increase in the final months of this year and quarterly increases in 2010.

So when will the money start flowing?

Previous EU-backed reform efforts in Ukraine have foundered, and the friction between Tymoshenko and President Viktor Yushchenko has created such political gridlock that Roget's should list their surnames under "hopeless." The EU has to keep the carrot far enough from the stick to maintain long-term pressure on the government while simultaneously preventing a new crisis.

As a result, the EBRD will probably offer the $300 million soon to help foot Ukraine's several-hundred-million-dollar monthly bill to Gazprom, contingent, perhaps, on a continued commitment to gas price increases. (The International Monetary Fund has allowed Ukraine to use funds from its larger financial crisis bailout for the same purpose.) But the lenders will have to keep their leverage by withholding larger payments until next year, when further changes, such as upgrading the existing gas transit system to increase efficiency, will be more politically manageable.

This is a tricky tack, no doubt, but one that just might work, given the severity of Ukraine's financial crisis.

"Crisis cuts both ways, doesn't it?" Valasek said. "Yes, this is a country that has had a dysfunctional generation of politicians in place, but it appears the possibility of an actual default and another gas crisis is focusing their minds."

"Ukraine has never failed to miss an opportunity over the past several years. The difference this time," he continued, adding that the days of 8 percent growth are over and that Kyiv needs money, "is that this time it's serious."